Vertical Specialization, Tariff Shirking, and Trade

Vertical Specialization, Tarif Shirking and Trade
Alyson C. Ma and Ari Van Assche

No. 390 | February 2014
ADB Economics
Working Paper Series
We develop a theoretical model in which vertical specialization gives frms the fexibility to
circumvent country-specifc tarif changes by switching their assembly location abroad. Using
frm-level and province-level export data from the Peoples Republic of China, we provide
evidence in line with the theoretical model.
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ADB Economics Working Paper Series

Vertical Specialization, Tariff Shirking, and Trade


Alyson C. Ma is Associate Professor of Economics,
University of San Diego. Ari Van Assche is Associate
Professor of International Business at HEC Montral and
Senior Fellow at CIRANO and the Institute for Research
on Public Policy.

www.adb.org

2014 by Asian Development Bank
February 2014
ISSN 1655-5252
Publication Stock No. WPS146313

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CONTENTS

ABSTRACT v

I. INTRODUCTION 1

II. VERTICAL SPECIALIZATION AND TRADE POLICY 2

III. MODEL 3

A. No Vertical Specialization 5
B. Vertical Specialization 6
C. Southern Firms 7
D. Northern Firms 7

IV. EMPIRICAL ANALYSIS 11

A. Province-level Analysis 13
B. Firm-level Analysis 14

V. CONCLUDING REMARKS 17

APPENDIX A: NO VERTICAL SPECIALIZATION 18

APPENDIX B: VERTICAL SPECIALIZATION 19

REFERENCES 21

ABSTRACT

The core idea behind the paper is that trade policy matters for the organization of
global value chains, a notion largely neglected by economists but which has
important implications for our understanding of trade and the international
transmission of trade policy shocks. We develop a theoretical model in which a
firms ability to spatially separate manufacturing from headquarter services gives
them the flexibility to circumvent economy-specific tariff changes by switching
their assembly location abroad. We show that tariff shirking increases the
elasticity of bilateral trade to economy-specific tariff hikes due to an extra
extensive margin effect. Furthermore, we show that tariff shirking affects the
vulnerability of headquarter services and manufacturing to trade policy shocks in
opposite ways. While tariff shirking dampens the vulnerability of headquarter
services to trade policy shocks, it amplifies the vulnerability of manufacturing to
trade policy shocks. Using firm-level and province-level export data from the
Peoples Republic of China, we provide evidence in line with the theoretical
model.

Keywords: vertical specialization, extensive margin, antidumping, tariff shirking,
Peoples Republic of China

JEL Classification: F12, F13, F14

I. INTRODUCTION

The organization of production has changed in the past few decades. Groundbreaking
advances in transportation and communications technology have enabled firms to separate
value chain tasks in space and time (Grossman and Rossi-Hansberg 2008). Recent studies
have extensively investigated how this added organizational flexibility allows firms to arbitrage
factor cost and institutional differences across economies, leading to the emergence of global
value chains (see Van Assche [2012] for an overview).

An additional benefit related to the slicing up of value chains, which has received less
attention, is that it allows firms to more easily circumvent trade policy barriers. To avoid an
economy-specific trade barrier, a company no longer has to relocate its entire value chain to
another economy, but only a single value chain stage, often final assembly. Fung, Fung, and
Wind (2007, pp. 5859), for example, describe how the trading company Li & Fung scrambled
to restructure its value chain in response to an unexpected trade policy shock:

[O]n a Friday in early September 2006, the South African government
announced that it would be imposing strict quotas on Chinese imports in two
weeks. Li & Fung had orders already in production for South African retailers that
would be affected by these changes. Managers began to look at contingency
plans to move production to factories in different countries and even to move the
last stage of existing orders to different end countries to satisfy non-[Peoples
Republic of] China country-of-origin rules.

The trading companys urge to restructure its value chain to circumvent trade barriers
implies that tariff shirking may be a powerful force affecting trade patterns. A firms ability to
circumvent trade policy, in turn, may have important implications for the effectiveness of trade
policy to protect domestic firms and for the transmission of trade policy shocks along different
parts of the value chain.

In this paper, we present an analytical framework that allows us to investigate the effects
of tariff shirking on trade. We build on the heterogeneous firm models by Melitz (2003) and by
Chaney (2008), but allow Northern firms to manufacture their goods either in their home
economy (local value chain) or in the South (global value chain). We show that this added
organizational flexibility makes it profitable for some Northern firms (at the margin) to circumvent
economy-specific tariff hikes by relocating its manufacturing. For example, if tariffs increase on
Southern exports, some Northern firms will reshore their manufacturing to their home economy,
leading to an extensive margin effect. Several strong results emerge from the model. First, tariff
shirking reduces the effectiveness of trade policy to protect a domestic industry since it provides
foreign companies with an extra tool to circumvent economy-specific tariffs. Second, vertical
specialization increases the elasticity of bilateral exports to economy-specific tariff hikes. Third,
Southern exports that are part of global value chains are more sensitive to an economy-specific
tariff hike than Southern exports that are part of local value chains. Fourth, the effect of trade
policy is distributed unevenly along the value chain. While tariff shirking dampens the
vulnerability of headquarter services to trade policy shocks, it amplifies the vulnerability of
manufacturing to trade policy shocks.

Guided by the theory, we empirically investigate the prediction that Southern exports that
are part of global value chains are more sensitive to an economy-specific tariff hike than
Southern exports that are part of local value chains. For this purpose, we draw on both firm-
level and provincial-level data from the customs statistics of Peoples Republic of China (PRC).
2 ADB Economics Working Paper Series No. 390
We do so by making a distinction between Chinese exports under two separate customs
regimes: processing trade and ordinary trade. As both Kee and Tang (2013) and Koopman,
Wang, and Wei (2012) have illustrated, processing exports are predominantly part of global
value chains, while ordinary exports more extensively use domestic value chains. In line with
our theoretical predictions, we find strong evidence that processing exports are more sensitive
to the imposition of antidumping measures than ordinary exports. This is mostly due to the
extensive margin effect identified in the theoretical model.

The rest of the paper is organized as follows. In section II, we survey the related
literature on trade policy and global value chains. In section III, we present the theoretical model
and discuss our central predictions. Section IV presents the data and methods used for our
empirical analysis. Section V talks about the implications for policy and we finally conclude.

II. VERTICAL SPECIALIZATION AND TRADE POLICY

The growing ability of companies to separate value chain tasks in space and time is intrinsically
related to the modularization of product architectures. Ulrich (1995) defines a product as a
combination of componentsor modulesthat interact with one another according to the
design rules of its product architecture. Products architectures can vary on a continuum from
integral to modular depending on the number of interdependencies between modules (Schilling
2000). If the product architecture is integral, modules are highly interdependent and require
constant monitoring and tacit interactions. In that case, geographically separating value chain
activities is hard to do since it requires significant coordination efforts (Fort 2011). In contrast, if
the product architecture is modular, then the modules interact through codified (and often
digitized) interfaces, which make them relatively independent from one another. In that case,
modules can be geographically separated at a relatively low coordination cost.

The emergence of e-mail, the Internet and common communications protocols, as well
as the increased availability of high-capacity computing power, has made it easier for firms to
modularize their product architecture. Currently, many companies rely on sophisticated
computer-aided design (CAD) technologies and business-to-business (B2B) systems to share
codified information between geographically separated locations. These technologies allow
them to perform tasks in geographically dispersed locations with limited risk of
miscommunication and with a relatively modest cost of monitoring (Blinder 2006, Leamer and
Storper 2001, and Levy and Murnane 2003). Indeed, Fort (2011) estimates that United States
(US) companies that use CAD technology to coordinate shipments have fragmented their
international production processes more extensively than companies without CAD technology.

A vast literature in international trade has investigated how the added organizational
flexibility related to the modularization of product architectures allows firms to arbitrage cost
differences across economies. Beyond the traditional sources of comparative advantage such
as technological differences and relative endowments, scholars have pinpointed new sources of
comparative advantage for task trade. Focusing on the fact that global value chains often
involve multiple companies that sign contracts with each other, one stream of literature has
identified the quality of an economys judiciary system can act as a source of comparative
advantage (Acemoglu, Antrs, and Helpman 2007; Costinot 2009; Levchenko 2007; and Nunn
2007). Other studies have focused on the quality of an economys transportation infrastructure
(Gamberoni, Lanz, and Piermartini 2010) and labor markets (Helpman and Itskhoki 2010) as a
source of comparative advantage.
Vertical Specialization, Tariff Shirking, and Trade 3
Less attention has been paid to trade policy barriers as a cost factor that can be
arbitraged through the restructuring of the value chain.
1
The literature has largely considered
trade policy barriers as a factor that reduces a firms incentive to slice up its value chains.
Focusing on worldwide tariffs, Yi (2003) shows that they have a higher impact on the cost of
trade within global value chains as compared with regular trade (i.e., trade of final goods fully
produced in a single economy), since the same component needs to cross borders multiple
times. As a result, he predicts that a relatively small rise in worldwide tariffs or other trade
barriers will deter many firms from fragmenting production internationally, therefore leading to a
large drop in trade.
2

In Yis (2003) model, the ability to fragment production internationally does not provide
firms with added flexibility to circumvent tariffs, since tariffs worldwide are assumed to uniformly
move up or down. The literature on tariff jumping, then again, provides insights into the effect of
tariff changes on the spatial structure of production. Belderbos and Sleuwaegen (1998) and
Blonigen (2002) provide evidence that many firms react to an economy-specific tariff increase or
antidumping measure by moving their production to the destination economy, therefore avoiding
the trade barrier. Blonigen, Tomlin, and Wilson (2004) show that such tariff jumping foreign
direct investment (FDI) reduces the effectiveness of trade policy to protect domestic firms.

Surprisingly, the international trade literature has paid limited attention to tariff shirking
as a strategy to avoid economy-specific changes in trade policy. Distinct from tariff jumping
where the firm moves production to the destination economy or region, a firm under tariff
shirking would try to circumvent the trade policy barrier by moving manufacturing to a third
economy that does not face the trade policy barrier.
3
Arguably, vertical specialization has made
tariff shirking easier since firms only need to move a part of their value chain instead of their
entire value chain. In the next section, we move to set up a theoretical model that allows us to
analyze the mechanism of tariff shirking and the effect on trade.

III. MODEL

Our model builds on the firm heterogeneity models of Melitz (2003) and Chaney (2008), but
allows firms to manufacture their final goods either in their home economy (local value chain) or
in a Southern economy (global value chain). Consider a world with many small Northern
economies and a small Southern economy. In each economy ], households spend the fixed
amount
]
> u on a specific differentiated goods sector. The demand function for a variety : in
this sector produced in economy i and sold in economy ] equals:

y
]
(:) = A
]
p
]
(:)
-s
, (1)

1
Konings and Vandenbussche (2013) provide evidence that antidumping measures on imported inputs negatively
affect firms exports. However, they do not analyze whether firms react to this through tariff shirking.
2
Escaith and Diakantoni (2012) and Miroudot and Rouzet (2013) use international inputoutput matrices to
estimate the effective protection rates when components cross borders multiple times.
3
There is a recent literature on export platform FDI that investigates the drivers of a firms decision to conduct FDI
in a third economy (Ekholm, Forslid, and Markusen 2007; Grossman, Helpman, and Szeidl 2006; Ito 2013;
Mrzov and Neary 2013). However, these studies have mainly focused on the effect of uniform changes in trade
costs across economies, and not on the effect of economy-specific changes in trade costs, therefore ruling out
tariff shirking. Furthermore, they have not considered the implications for the effectiveness of trade policy.
where e =
1
1-u
> 1 is the elasticity of substitution between any pair of differentiated
goods and the demand level A
]
is exogenous from the point of view of the individual firm and
the individual economy (due to the small economy assumption).
4

Exports from economy i to economy ] are subject to an ad valorem tariff t
]
, where
]
= 1 + t
]
. Tariffs are economy-specific and vary across economies. The tariff implies that the
consumer price in economy ] is higher than the domestically charged price (i.e., in economy i):

p
]
(:) = p
(:)(1 + t
]
) = p
(:)
]
, (2)

where p
(:) is the domestic price.

In each economy, a continuum of firms has the know-how to produce a single variety.
We assume that each firm draws a productivity from a cumulative Pareto distribution
0() with shape parameter z > e 1(Helpman, Melitz, and Yeaple 2004):

0() = 1
-z
. (3)

An inverse measure of the heterogeneity in a sector is given by z. If z is high, firms are
more homogeneous, in the sense that more output is concentrated among the smallest and
least productive firms. We assume that all economies face an identical Pareto distribution
function.

The value chain of a product consists of three stages: knowledge-intensive headquarters
service production, labor-intensive manufacturing and final sale. A firm is required to produce its
headquarter services in its home economy. Manufacturing, in contrast, is footloose and can be
conducted either in a Northern economy at a fixed unit labor cost of
N
or in South at a fixed
unit labor cost of
S
. If manufacturing is not co-located with headquarters services, the firm
faces a fixed cost g of coordinating its global value chain activities across borders. Finally, to
sell its product variety to consumers in the destination economy ], a firm faces a fixed cost .

In our model, we assume that wages are fixed and are lower in South than in the
Northern economies,
S
<
N
. Furthermore, we assume that the following condition holds:
5

[
o
N
o
S
s-1
[
:
N
:
S
s
> 1. (4)

Under this condition, any firm has a marginal cost advantage of manufacturing its
products in the South compared to the North. In other words, the wage advantage of
manufacturing in the South is sufficiently large to outweigh a potential tariff advantage of
exporting the final good from the North.

Without loss of generality, we will focus on the strategies of firms from a single Northern
economy l = N and from South l = S that sell their products to a specific Northern destination

4
As is well known from previous studies, A
|] p
(:)
1-s
J:
n
i
0
] , , where n
is the measure of varieties available in

economy i and p
(:) is the price of variety : in economy i. Firms treat A
as fixed since they are too small to

individually affect A
.
5
Under this condition, the marginal profit of manufacturing a unit in the South exceeds the marginal profit of
manufacturing a unit in the North. One can obtain this condition by using equation (6).
economy ] . For notational clarity, we will drop the subscript ] that identifies the destination
economy.

We solve the model in two steps. In section III.A, we analyze the benchmark scenario of
no vertical specialization where Northern and Southern firms are required to spatially co-locate
headquarter services and manufacturing. In section III.B, we then study the scenario of vertical
specialization where it becomes optimal for some Northern firms to slice up their value chain
and offshore their manufacturing to a Southern economy. By comparing the equilibrium
outcomes of both scenarios we can investigate how the extra organizational ability of slicing up
the value chain affects the elasticity of exports to economy-specific tariff changes.

A. No Vertical Specialization

Consider the benchmark case where g approaches infinity so that all firms are better off co-
locating manufacturing with headquarter services.
6
This is in line with the scenario where the
product architecture is integral so that it is difficult to spatially disperse value chain activities.
From equations (1) and (2), firms from l e {N, S] choose y to maximize n
I
= [p
I

o
l
q
y
I
. It is
straightforward to check that this program yields the optimal price p
I
=
o
l
uq
, the optimal firm-
specific exports:

x
I
=
B
1-u
[
q
o
l
s-1
I
-s
, (5)

and the optimal firm-specific profit:

n
I
= [
q
o
l
s-1
I
-s
B , (6)

where B = (1 o)Ao
s-1
. Intuitively, equations (5) and (6) suggest that a firms exports
and profits decline with the rise of its home economy ls wages
I
and the economy-specific
tariffs it faces
I
.

Not all firms are able to generate enough profits to cover the fixed cost of exporting to
the destination economy. Define
I
as the threshold productivity at which n
I
= u. Using equation
(6), the cut-off productivity coefficient for firms in economy l equals:

I
=
I
[
]
B
1
s-1
I
s
s-1
. (7)

From equation (6), it is clear that less productive firms with <
I
do not export to the
destination economy, while firms with >
I
become exporters.

Economy ls aggregate exports to the destination economy equal the sum of exports by
firms with >
I
. Using the firm-level export equation (5), the aggregate export equation
equals:

6
Alternatively, we could cut off the productivity at a maximum value.
X
I
= ] x
I
()J0()
q
l
=
B
1-u
I
-s
] [
q
o
l
s-1
J0().
q
l
(8)

We can use equation (8) to investigate the elasticity of aggregate exports X
I
with respect
to an economy-specific tariff change
I
. As illustrated by Chaney (2008), the effect can be
decomposed into two different margins:

dX
l
d :
l
X
l
:
l
=
:
l
X
l
[]
x
l
(q)
:
l
J0()
q
l
+
:
l
X
l
[x
I
(
I
)0
i
(
I
)
q
l
:
l
, (9)

where the first term is the intensive margin and the second is the extensive margin. The
intensive margin determines by which amount existing exporters (or incumbents) change the
size of their exports. The extensive margin defines the amount that aggregate exports change
due to firm entry and exit. In Appendix A, we solve equation (9) to obtain the elasticity of an
economys exports to an economy-specific tariff change:

dX
l
X
:
l
d:
l
= e + (z (e 1))
s
s-1
. (10)

There are two important aspects to note about this elasticity. First, the elasticity differs
from Chaney (2008) because we model trade barriers as ad valorem tariffs and not as iceberg
transport costs. As Cole (2011) shows, the use of ad valorem tariffs implies that, unlike in
Chaney (2008), the elasticity of trade with respect to trade barriers is a function of the elasticity
of substitution between product varieties. It is important to emphasize, however, that the central
predictions of our model would be unaffected if we had used iceberg transport costs. Second,
due to our assumption that the productivity dispersion is identical across economies, the
elasticity of aggregate exports with respect to an economy-specific tariff change is the same for
both Northern economies and South. In the remainder of the paper, we will use equation (10) as
a benchmark to investigate how vertical specialization alters the impact of economy-specific
trade policy shocks on trade.

B. Vertical Specialization

Consider next the scenario where the fixed coordination costs g are within the parameter range
_[
:
N
:
S
s
[
o
N
o
S
s-1
1_ < g < +. In that case, it is only optimal for the most productive Northern
firms to locate their manufacturing in the South.
7
As Figure 1 illustrates, three organizational
forms coexist in the industry under this condition: (i) Southern firms with local value chains, (ii)
Northern firms with local value chains, and (iii) Northern firms with global value chains. In the
remainder of this section, we estimate the elasticity of exports with respect to economy-specific
tariffs for these three organizational forms.

7
If g < _[
:
N
:
S
s
[
o
N
o
S
s-1
1_, it is optimal for all Northern firms to manufacture in the South. In this unrealistic case,
there will be no extra extensive margin effect and the elasticity of bilateral exports with respect to a country-
specific tariff change reverts to that of the case of no vertical specialization.
Figure 1: Types of Organizational Forms Exporting to the Destination Economy

Source: Authors depiction

C. Southern Firms

Due to the marginal cost advantage of manufacturing in the South, there is no benefit for
Southern firms to manufacture their goods in the North. As a result, all Southern firms continue
to co-locate manufacturing with headquarter services in the South and the analysis is identical
to section III.A. The elasticity of Southern firms exports with respect to an economy-specific
tariff change thus equals:

dX
S
X
S
:
S
d:
S
= e + (z (e 1))
s
s-1
. (11)

D. Northern Firms

As illustrated in Figures 1 and 2, two types of Northern firms sell their products to the destination
economy: less productive firms (
N
< <
N0
) which manufacture in the North and more
productive firms ( >
N0
) which manufacture in the South. We consider their optimization
problems in turn.

For Northern firms with a domestic value chain (
N
< <
N0
), the profit maximization
problem is identical to section III.A. Firm-specific profits amount to n
N
= [
q
o
N
s-1
N
-s
B ,
which imply that firms with a productivity below
N
=
N
[
]
B
1
s-1
N
s
s-1
do not export to the
destination economy. Firm-specific exports amount to x
N
=
B
1-u
[
q
o
N
s-1
N
-s
.

Headquarter
service
Manufacturing
Sales
Sales
Manufacturing
Headquarter
service
Headquarter
service
Manufacturing
Sales
Southern firm
with local value
chain
DESTINATION
SOUTH
NORTH
Figure 2: Productivity and Northern Firms Organizational Form

Source: Authors calculations

Northern firms with a global value chain ( >
N0
) perform their manufacturing in the
South and choose y to maximize n
N0
= [p
o
S
q
y g. For these firms, their optimal price
equals p
N0
=
o
S
uq
, their firm-specific exports equal:

x
N0
=
B
1-u
[
q
o
S
s-1
S
-s
, (12)

and their firm-specific profits equal:

n
N0
= [
q
o
S
s-1
S
-s
B g. (13)

Using equations (5) and (13), the threshold at which n
N
(
N0
) = n
N0
(
N0
) equals:

N0
= _
g
B_o
S
1-s
:
S
-s
-o
N
1-s
:
N
-s
]
_
1
s-1
. (14)

The Northern firms with a productivity >
N0
manufacture in the South, while firms
with a productivity
N
< <
N0
manufacture in the North.

1. Aggregate Exports by Firm Type

Aggregate exports from North by firms with domestic value chains, X
N
, equals the integral of
firm-level exports x
N
for firms with a productivity
N
< <
N0
. Using equation (5):

X
N
= ] x
N
()J0()
q
NO
q
N
. (15)
Non-exporters
Northern firms with
domestic value
chain
Northern firms with
global value chain

0

1
( )
NO
1
( )
k

NO
( ) f g +
k

Aggregate exports from South by Northern firms with global value chains, X
N0
, equals
the integral of firm-level exports x
N0
for Northern firms with a productivity >
N0
. Using
equation (12):

X
N0
= ] x
N0
()J0()
q
O
. (16)

We can use these aggregate export equations to investigate if vertical specialization
affects the elasticity of exports with respect to economy-specific tariffs.

2. Impact of an Increase in
S
on X
N0

We first investigate the impact of an ad valorem bilateral tariff increase
S
on X
N0
. In Appendix
B, we use equation (16) to calculate that the elasticity of X
N0
with respect to
S
equals:

dX
NO
d :
S
X
NO
:
S
= e + (z (e 1))
s
s-1
_, (17)

where _ =
_
n
N
n
S
]
s-1
_
S
]
s
_
n
N
n
S
]
s-1
_
S
]
s
-1
> 1.

Due to our assumption in equation (4) that there is a marginal cost advantage of
manufacturing in the South compared to the North, _ > 1. As a result, if we compare to equation
(10), Northern firms exports from South,X
N0
, are more elastic with respect to an increase in
S

than their exports were under no vertical specialization. This result is driven by an extra
extensive margin effect related to tariff shirking. If
S
increases, it induces an extra number of
firms to stop exporting from economy S since they move assembly back to N to circumvent the
tariff hike. Note that the extra elasticity denoted by _ is larger if the marginal cost advantage of
manufacturing in the South is smaller. In other words, the smaller the marginal cost advantage
of manufacturing in the South, the more X
N0
would be affected by tariff shirking.

Compared to equation (11), Northern firms exports from South, X
N0
, is also more elastic
than Southern firms exports from South, X
S
, with respect to an increase in
S
. This is once
again because some Northern firms (at the margin) have the extra flexibility to circumvent the
tariff increase by reshoring manufacturing back to the North. An implication of the difference in
elasticities between Southern exports conducted by Northern and Southern firms is that an
increase in
S
will reduce the share of Southern exports conducted by Northern firms. Define
s
N0
as the share of Southern exports conducted by Northern firms:

s
N0
=
X
NO
X
NO
+X
S
. (18)

By taking the derivate of equation (18) and using the elasticities in equations (11) and
(17), it is straightforward to show that the share s
N0
is negatively affected by a rise in
S
:

s
NO
:
S
=
1
:
S
s
N0
(1 s
N0
)(z (e 1))
s
s-1
(_ 1) < u. (19)

In our empirical analysis, we will further investigate this specific prediction of the model.

3. Impact of an Increase in z
N
on X
N

We next investigate the effect of an ad valorem bilateral tariff increase
N
on X
N
. In Appendix B,
we use equation (15) to calculate that the elasticity equals:

dX
N
d :
N
X
N
:
N
= e + (z (e 1))
s
s-1
_1 +
X
NO
X
N

1
_
n
N
n
S
]
s-1
_
S
]
s
-1
_. (20)

If we compare to the scenario of no vertical specialization in equation (10), it is clear that
X
N
is more elastic with respect to
N
under vertical specialization than under no vertical
specialization since
X
NO
X
N

1
_
n
N
n
S
]
s-1
_
S
]
s
-1
> u. This result is once again due to an extra extensive
margin effect. The logic is the following. Compared to no vertical specialization, a tariff hike not
only induces a number of Northern firms to become non-exporters, but also causes a number of
firms to divert their exports through the South in order to circumvent the tariff increase. This
extra tariff shirking effect at the extensive margin, which is driven by the ability to fragment
assembly from input production, increases the elasticity of X
N
with respect to
N
.

The extra elasticity once again depends on the size of the marginal cost advantage of
manufacturing in the South. The smaller this marginal cost advantage is, the more sensitive is
X
N
to an economy-specific tariff hike.

4. Sensitivity of Production Stages to Trade Policy Shocks

Finally, we investigate whether vertical specialization affects the impact of a tariff increase
differentially along the two vertical stages of the value chain: (non-footloose) headquarters
services and (footloose) manufacturing.

It is straightforward to show that vertical specialization reduces the vulnerability of
sectorwide headquarter services in the North to an economy-specific tariff increase
N
or
S
. The
intuition is the following. Since a number of companies (at the margin) are able to dampen the
effect of the tariff hike by relocating their manufacturing, the demand for products sold by firms
from N is less affected by the tariff hike than under the no-vertical-specialization scenario. As a
result, non-footloose headquarters service production in economy N is also less vulnerable to
the tariff hike.

In contrast, vertical specialization increases the vulnerability of manufacturing activities
in both economy N and S to an economy-specific tariff increase
N
or
S
. As Northern companies
(at the margin) relocate their manufacturing to circumvent tariffs, footloose manufacturing
activities become particularly vulnerable to trade policy shocks. Manufacturing in economy N,
for example, is extra vulnerable to an increase in
N
since it induces a number of firms to cease
manufacturing in N and offshore it to S . Similarly, manufacturing in economy S is extra
vulnerable to an increase in
S
since it induces a number of Northern firms to cease production
in S and reshore it to economy N.

IV. EMPIRICAL ANALYSIS

A key prediction from the model is that Southern exports that are part of global value chains are
more elastic with respect to an economy-specific tariff hike than Southern exports that are part
of local value chains. As a result, an economy-specific tariff hike should reduce the share of
exports that are part of global value chains. In this section, we draw on both province-level
(19972009) and firm-level (20002006) data from PRC customs statistics to investigate this
claim.

To classify PRC exports that are part of global versus local value chains, we distinguish
between two customs regimes: processing trade and ordinary trade. These two trade forms
differ in terms of tariff treatment and the ability of firms to sell in the domestic market:

Under the processing trade regime, firms enjoy the right of duty-free imports of
intermediate goods and capital equipment that are used in their export processing
activity, but face restrictions in selling to the domestic market.
Under the ordinary trade regime, firms need to pay import duties on imported inputs but
can sell their output locally.

Due to these distinct characteristics the processing trade regime is used primarily by
exporting firms that are part of a global value chain, while the ordinary trade regime is used by
exporting firms that have more extensive domestic value chains. Two stylized facts back this up.
First, recent estimates suggest that processing exports embody less than half as much
domestic value added than ordinary exports (Kee and Tang 2013; Koopman, Wang, and Wei
2012). Second, as is shown in Figure 3, foreign-owned firms play a much more dominant role in
the processing trade regime than in the ordinary trade regime. Between 1997 and 2009, the
share of processing exports conducted by foreign-owned enterprises increased from 64% to
85%. In comparison, this share throughout the sample period remained under 30% in the
ordinary trade regime. We use this distinction to evaluate the theoretical prediction that exports
are more sensitive to economy-specific trade policy shocks under the processing trade regime
than under the ordinary trade regime.

As our measure of economy-specific trade policy shocks, we use antidumping cases
against the PRC as identified in the Global Antidumping Database (GAD) published by the
World Bank (Bown 2009). The benefit of using antidumping as a measure for an economy-
specific trade policy shock is that it is generally imposed by an economy on firms of a specific
economy, and not across the board. The GAD has detailed information on each antidumping
case, such as product information (6-digit HS codes), the investigating economy, the target
economy, the preliminary determination date and the year it was revoked. For our analysis, we
collect information on all antidumping cases against the PRC during the period 19972009. We
match the GAD data with the PRC customs data at the HS6 digit level, the most disaggregated
level at which the two datasets are comparable.

From 1997 to 2009 there were a total of 1,042 cases of which 1,011 were in the
manufacturing sector. We focus our study on the manufacturing sector, which is more in line
with the theory presented on vertical specialization. Over the 12-year period in the data set, the
average number of cases was 78 per year with a median of 61 cases. The antidumping charges
were imposed on $131 billion of PRC exports, which represented 1.75% of total PRC exports in
manufacturing. Table 1 shows that the number of cases increased by 162% from 55 to 144
between 2000 and 2001. The number of cases also spiked in 2006 with 127 cases (up by 22%)
and again in 2008 and 2009 with 110 and 158 cases, respectively. The table also shows that
the US held the most antidumping charges against the PRC with about a quarter of the total
number of cases. The next three largest initiators are India, the European Union, and Canada
with 15%, 12%, and 10%, respectively.

Figure 3: Share of the Peoples Republic of Chinas Exports Conducted by Foreign-
owned Enterprises, by Customs Regime, 19972009 (%)

Source: Authors calculations using data from the Peoples Republic of Chinas Customs Statistics

Table 1: Summary Statistics of Preliminary Anti-dumping Decisions Imposed against the
Peoples Republic of China, by year and economy

Year of Preliminary Anti-dumping Decision
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Total
India 1 8 3 9 21 8 24 2 9 11 6 11 36 149
Indonesia 8 3 0 0 0 0 0 0 0 0 0 0 0 11
Israel 0 0 2 0 0 0 0 0 1 3 4 0 0 10
Malaysia 0 0 0 0 0 1 0 0 0 0 0 0 0 1
Pakistan 0 0 0 0 0 0 0 0 1 4 0 0 4 9
Philippines 0 0 0 1 0 0 0 0 0 0 0 0 0 1
Republic of Korea 3 2 0 1 0 0 9 2 2 3 4 7 0 33
Turkey 0 0 0 0 0 2 0 0 0 0 0 0 0 2
Taipei,China 0 0 0 0 0 0 0 0 0 14 0 0 0 14
South Africa 13 4 0 1 2 1 0 1 3 4 2 3 1 35
European Union 11 20 2 6 3 1 3 2 20 20 5 7 21 121
Argentina 8 0 2 0 11 6 1 4 1 5 2 17 38 95
Brazil 0 2 0 0 0 0 0 0 0 5 3 2 16 28
Colombia 0 0 0 0 0 0 0 2 1 47 2 7 3 62
Mexico 1 1 1 0 5 1 3 1 2 2 2 3 0 22
Peru 0 1 6 0 11 4 1 1 0 0 0 0 0 24
Trinidad and Tobago 0 0 0 1 0 0 0 6 0 0 0 0 0 7
Venezuela 0 0 13 0 0 0 0 0 0 0 0 0 0 13
Canada 2 0 0 11 43 2 3 8 1 2 1 10 17 100
United States 13 0 2 25 46 50 5 42 3 5 5 42 15 253
Australia 1 0 0 0 2 3 0 3 1 2 0 1 7 20
New Zealand 0 0 0 0 0 0 0 1 0 0 0 0 0 1
Total 61 41 31 55 144 79 49 75 45 127 36 110 158 1,011
Source: Authors calculations using the Global Anti-Dumping Database
0
20
40
60
80
100
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
%
Ordinary trade Processing trade
A. Province-level Analysis

In a first step, we use more aggregate province-level data for the time period 19972009 to
investigate if antidumping disproportionately affects processing exports compared to ordinary
exports. In our analysis, our dependent variable is the share in value of bilateral exports that is
organized through processing trade in a specific HS 6-digit industry and year:

Sorc
]kt
=
PX
i]kt
PX
i]kt
+0X
i]kt
, (21)

where PX
]kt
is the value of Chinese processing exports from province i to economy ] in
industry kand year t, and 0X
]kt
is the value of Chinese ordinary exports from province i to
economy ] in industry k and year t. To test the prediction of the theoretical model, we estimate
the following regression equation:

Sorc
]kt
= o
+o
k
+ o
t
+ [ A
]kt
+
Ijkt
, (22)

where o
, o
k
and o
t
are province, industry and year fixed effects; A
]kt
is a dummy
variable that takes on a value of 1 when a HS 6-digit export industry k faces an anti-dumping
measure imposed by economy ] in a year t and 0 otherwise; and
Ijkt
is an error term. There will
be evidence that an anti-dumping measure disproportionately affects processing trade if the
OLS estimate [
`
is negative and significant.

The results of the benchmark analysis are presented in Column 1 of Table 2. The
negative and significant coefficient on the antidumping indicator suggests that the share of
processing exports declines after the imposition of antidumping duties. Specifically, an
antidumping imposition reduces the share of processing exports by 7.6%. We can infer from this
that processing exports are considerably more sensitive to the imposition of antidumping duties
than ordinary exports.

Table 2: Province-level Estimation Results

Dependent Variable: Share
|jkt

Benchmark Foreign PT/Domestic OT Foreign PT/Domestic OT/only AD sectors
(1) (2) (3)
AD 7.590***
(0.606)
8.371***
(0.720)
11.118***
(0.736)
Year FE Yes Yes Yes
Sector FE Yes Yes Yes
Province FE Yes Yes Yes
Observations 931,293 713,761 410,630
R
2
0.16 0.19 0.18
AD = anti-dumping, FE = fixed effects, OT = ordinary trade regime, PT = processing trade regime.
Note: Coefficients are reported with robust standards errors that are clustered at the province level. Standard errors are given in
parentheses. The individual coefficient is statistically significant at the *10%, **5%, or ***1% level.
Source: Authors calculations using the Global Anti-Dumping Database and data from the Peoples Republic of Chinas Customs
Statistics

In Column 2 of Table 2, we test whether the results are sensitive to excluding Chinese
firms that conduct processing exports and foreign firms that conduct ordinary exports. This
restriction aligns the empirical estimation better to the theory that Southern exports within global
value chains are conducted by Northern firms, while Southern exports within local value chains
are conducted by Southern firms. The results are similar to the benchmark analysis, with a
slightly larger reduction of 8.4% in the share of processing exports.

In Columns 3 of Table 2, we, as an additional robustness test, exclude all industries
from our data sample in which no antidumping was imposed during the entire sample period
(19972009). The results are once again similar to the benchmark analysis, with a larger
reduction of 11.1%.

B. Firm-level Analysis

The province-level data do not allow us to examine the impact of antidumping impositions on
the intensive and extensive margin separately. To distinguish these two effects, we therefore
utilize more disaggregated firm level data from Chinese customs statistics that are only
available for the subsample 2000 to 2006.

We define intensive margin as exports by incumbent firms. To be considered as an
incumbent, a firm must have at least one year of positive exports in an industry affected by anti-
dumping prior to the imposition of the antidumping charges and at least one year of positive
exports after the imposition. For example, a firm exporting a girls 16 inch bike to the US in
years 20012004 would be considered an incumbent if the US imposed an antidumping charge
on the PRC for the item in year 2002.
8

We define extensive margin as exports by non-incumbent firms (Morrow and Brandt
2013). In other words, the extensive margin captures exports by firms that did not export in a
year prior to the imposition of antidumping charges or did not export in a year after the
imposition of antidumping charges.

To investigate if antidumping disproportionately affects processing exports compared to
ordinary exports at the intensive margin, we use the following dependent variable:

Sorc_Int
]kt
=
PX_Int
]kt
PX_Int
]kt
+0X_Int
]kt
, (23)

where PX_Int
]kt
is the value of processing exports to economy ] by incumbents in
industry kand year t, and 0X_Int
]kt
is the value of ordinary exports to economy ] by incumbents
in industry k and year t. Similar to above, we test our central prediction by estimating the
following regression equation:

Sorc_Int
]kt
= o
k
+ o
t
+ [ A
]kt
+
jkt
, (24)

where o
k
and o
t
are industry and year fixed effects; A
]kt
is a dummy variable that takes
on a value of 1 when a HS 6-digit export industry k faces an anti-dumping measure imposed by
economy ] in a year t and 0 otherwise; and
jkt
is an error term. There will be evidence that an

8
Given our definition of an incumbent, firms would not be considered in this category for years 2000 and 2006. As
such, we dropped these years in our estimation.
anti-dumping measure disproportionately affects processing trade at the intensive margin if the
OLS estimate [
`

To investigate if antidumping disproportionately affects processing trade compared to
ordinary trade at the extensive margin, we use the following dependent variable:

Sorc_Ext
]kt
=
PX_Lxt
]kt
PX_Lxt
]kt
+0X_Lxt
]kt
, (25)

where PX_Ext
]kt
is the value of processing exports to economy j by non-incumbents in
industry kand year t, and 0X_Ext
]kt
is the value of ordinary exports to economy ] by non-
incumbents in industry kand year t. Similar to above, we estimate the following regression
equation:

Sorc_Ext
]kt
= o
k
+o
t
+[ A
]kt
+
jkt
. (26)

There will be evidence that an anti-dumping measure disproportionately affects
processing exports at the extensive margin if the OLS estimate [
`

In Columns 13 of Table 3, we present the benchmark results for the share of
processing exports in total Chinese exports. The results for the pooled estimation, intensive
margin, and extensive margin are provided in Columns 1, 2, and 3, respectively. All three
specifications include year and sector fixed effects. We find that antidumping has a negative
impact on the share of processing exports across all three specifications, although it is only
significant at the 10% level for the intensive margin. When incumbent and non-incumbent firms
are pooled together, antidumping reduces the share of processing exports by 3.1%. When only
incumbents are considered (intensive margin), antidumping reduces the share of processing
exports by 2.1%. For non-incumbents (extensive margin), antidumping reduces the share of
processing exports by 2.4%.

Table 3: Firm-level Estimation Results and Decomposition using Value of Exports

Dependent: Share of Processing Exports in Total Value of Export
Benchmark Domestic OT/Foreign PT
Domestic OT/Foreign
PT/Import Cut off
Domestic OT/Foreign
PT/Import Cut off/AD
Pooled Intensive Extensive Intensive Extensive Intensive Extensive Intensive Extensive
(1) (2) (3) (4) (5) (6) (7) (8) (9)
AD 3.13***
(0.834)
2.07*
(1.147)
2.41**
(1.176)
3.247**
(1.402)
3.271**
(1.361)
4.021**
(1.420)
3.569**
(1.373)
2.451*
(1.468)
4.449***
(1.401)
Year FE Yes Yes Yes Yes Yes Yes Yes Yes Yes
Sector FE Yes Yes Yes Yes Yes Yes Yes Yes Yes
Observations 370,871 91,692 279,179 76,637 217,223 76,250 216,889 28,029 124,457
R
2
0.28 0.44 0.32 0.44 0.33 0.44 0.33 0.46 0.34
Note: Coefficients are reported with robust standards errors that are clustered at the FIRM level. Standard errors are given in
Statistics

Similar to the provincial-level estimation, we also conducted a number of robustness
tests of our firm-level results. First, in Columns 45 of Table 3, we solely considered processing
exports conducted by foreign-owned firms and ordinary exports by Chinese-owned firms. The
results are similar to the benchmark findings, but with larger negative magnitudes of 3.2% and
3.3% at the intensive and extensive margin, respectively.

The decision to impose antidumping could be considered endogenous since the foreign
firms that originate from the imposing economy may actively lobby for or against their
imposition. To address this possible endogeneity, we have therefore as a robustness test
eliminated from our data sample any firms that import more than 5% of its imports from an
economy that imposes antidumping.
9
The findings in Columns 67 of Table 3 suggest that it
leads to slightly larger decreases in exports.

Finally, in Columns 89, we exclude all industries from our data sample in which no
antidumping was imposed during the entire sample period. In this case, we find that the
coefficient on the antidumping indicator for the intensive margin is negative as in the benchmark
but at only the 10% significance level. The result predicts that the share of processing exports in
total exports by incumbents decreases by 2.5% in the presence of an antidumping measure.
The coefficient on the antidumping indicator for the extensive margin is highly significant and
with a larger magnitude than the benchmark. Specifically, the share of processing exports at the
extensive margin is reduced by 4.5% in reaction to antidumping.

In Table 4, we estimate our empirical specification using quantities instead of values. In
other words, we use as our dependent variable the share of processing exports in the total
quantity exported for years 2001 to 2005. The results confirm the previous results that
antidumping charges negatively affect the share of processing exports in total exports, both at
the intensive and extensive margin.

Table 4: Firm-level Estimation Results and Decomposition Using Quantity of Exports

Dependent: Share of Processing Exports in Total Quantity of Exports

Benchmark Domestic OT/Foreign PT
Domestic OT/Foreign
PT/Import Cut off
Domestic OT/Foreign
PT/Import Cut off/AD
Pooled Intensive Extensive Intensive Extensive Intensive Extensive Intensive Extensive
(1) (2) (3) (4) (5) (6) (7) (8) (9)
AD 2.83***
(0.819)
2.00*
(1.146)
2.36**
(1.186)
3.072**
(1.393)
2.746**
(1.365)
3.651**
(1.415)
2.459*
(1.366)
3.217**
(1.484)
3.724**
(1.391)
Year FE Yes Yes Yes Yes Yes Yes Yes Yes Yes
Sector FE Yes Yes Yes Yes Yes Yes Yes Yes Yes
Observations 370,224 91,571 278,653 76,537 216,691 76,156 216,358 27,994 124,167
R
2
0.28 0.45 0.32 0.45 0.33 0.45 0.33 0.47 0.34
Note: Coefficients are reported with robust standards errors that are clustered at the FIRM level. Standard errors are given in
Statistics

9
We would like to thank Laura Puzzello for suggesting this robustness test. The results are similar for other cut off
levels.
V. CONCLUDING REMARKS

The core idea behind the paper is that trade policy matters for the organization of global value
chains, a notion that seems to have been neglected by trade economists, but has major
implications for our understanding of trade and the international transmission of trade policy
shocks. To gain new insights into this research area, we have developed a theoretical model in
which a firms ability to spatially separate manufacturing from headquarter services gives them
the flexibility to circumvent an economy-specific tariff increase by relocating their manufacturing
elsewhere, a phenomenon that we have termed tariff shirking. We have illustrated a number of
general equilibrium implications of tariff shirking. First, we have shown that it increases the
elasticity of exports within global value chains to economy-specific trade policy shocks by
creating an extra extensive margin effect. Second, we have illustrated that tariff shirking
differentially affects the vulnerability of headquarters services and manufacturing to economy-
specific trade policy shocks. Whereas tariff shirking dampens the vulnerability of headquarters
services to trade policy shocks, it amplifies the vulnerability of manufacturing to trade policy
shocks. This last result is complementary to Bergin, Feenstra, and Hansons (2011) finding that
offshored assembly activities in Mexico are more vulnerable to US business cycle shocks than
corresponding US industries.

We used firm-level and province-level export data from the PRC to see if there is
evidence that Chinese exports that are part of global value chains are more sensitive to
antidumping measures than Chinese exports that rely on domestic value chains. The answer is
yes: processing exports that rely heavily on imported inputs are consistently more sensitive to
antidumping duties than ordinary exports. This result is found to be primarily driven by an
extensive margin effect.

While our empirical results apply only to the PRC, the economic logic is broader and
suggests that tariff shirking may be an important driver of trade and the international
organization of production, and an important determinant of the effectiveness of trade policy.
The policy implications of our analysis are complex. Policymakers may be inclined to try to
prevent tariff shirking and restore the effectiveness of economy-specific trade policy barriers by
linking them to rules of origin. Such a move, however, would further increase the administrative
complexity of trade and may even end up being detrimental for an economy. As Deardorff
(2013) shows, rules of origin can reduce or even eliminate completely the gains from trade. A
policy reaction that would be more in line with the spirit of the World Trade Organization would
be to step away from discriminatory trade policy barriers, which are less effective due to tariff
shirking, and to focus on non-discriminatory trade policy barriers that limit the potential of tariff
shirking.

APPENDIX A: NO VERTICAL SPECIALIZATION

The elasticity of aggregate exports X
I
with respect to economy-specific tariff
I
under no vertical
specialization can be separated into an intensive and an extensive margin effect:

dX
l
d :
l
X
l
:
l
=
:
l
X
l
[]
x
l
(q)
:
l
J0()
q
l
+
:
l
X
l
[x
I
(
I
)0
i
(
I
)
q
l
:
l
. (A-1)

Using the definition of equilibrium individual exports from equation (5) and using the
assumption that economy l is small enough so that a change in
I
does not affect B, we get:

dx
l
(q)
d:
l
= e
x
l
:
l
.

Inserting this into (A-1) and rearranging, we obtain:

dX
l
d :
l
X
l
:
l
= e +
x
l
(q
l
)u
|
(q
l
)q
l
X
l

:
l
q
l
q
l
:
l
. (A-2)

Using the definition of the distribution of productivity shocks 0
i
() = z
-z-1
from
equation (3) and the definition of firm-level exports from equation (5), we can rewrite aggregate
exports in the following way:

X
I
= _ x
I
()J0() =
q
l

= _
B
1 o
[
s-1
I
-s
z
-z-1
q
l
J

=
1
z-(s-1)
x
I
(
I
)0
i
(
I
)
I
.

Inserting this into (A-2), we obtain:

dX
l
d :
l
X
l
:
l
= e + (z (e 1))
:
l
q
l
q
l
:
l
. (A-3)

From equation (7), we can derive that
:
l
q
l
q
l
:
l
=
s
s-1
so that:

dX
l
X
l
:
l
d:
l
= e + (z (e 1))
s
s-1
=
zs
s-1
. (A-4)

APPENDIX B: VERTICAL SPECIALIZATION

1. Elasticity of aggregate exports X
NO
with respect to tariff z
S

We first calculate the elasticity of aggregate exports by Northern firms that manufacture in
South, X
N0
, with respect to tariff
S
. The elasticity can once again be separated into an intensive
and an extensive margin effect:

dX
NO
d :
S
X
NO
:
S
=
:
S
X
NO
[]
x
NO
(q)
:
S
J0()
q
NO
+
:
S
X
NO
[x
N0
(
N0
)0
i
(
N0
)
q
NO
:
S
. (B-1)

Using equation (12) and using the assumption that economy l is small enough so that a
change in
S

dx
NO
(q)
d:
S
= e
x
NO
:
S
.

Inserting this into (B-1) and rearranging, we obtain:

dX
NO
d :
S
X
NO
:
S
= e +
x
NO
(q
NO
)u
|
(q
NO
)q
NO
X
NO

dq
NO
q
NO
:
S
d:
S
. (B-2)

We can use the definition of firm-level exports from equation (12) and the definition of
the distribution of productivity shocks in equation (3) to rewrite aggregate exports in the
following way:

X
N0
= ] x
N0
()J0() =
q
NO
1
z-(s-1)
x
N0
(
N0
)0
i
(
N0
)
N0
. (B-3)

Inserting (B-3) into (B-2), we obtain:

dX
NO
d :
S
X
NO
:
S
= e + (z (e 1)) [
:
S
q
NO
q
NO
:
S
. (B-4)

We can use equation (14) to derive the elasticity of the cutoff condition
N0
with respect
to tariffs:

dq
NO
q
NO
:
S
d:
S
=
s
s-1
_ where _ =
_
n
N
n
S
]
s-1
_
S
]
s
_
n
N
n
S
]
s-1
_
S
]
s
-1
.

Inserting this elasticity into (B-4) gives:

dX
NO
d :
S
X
NO
:
S
= e + (z (e 1))
s
s-1
_. (B-5)

2. Elasticity of aggregate exports X
N
with respect to tariff z
N

We can next calculate the elasticity of aggregate exports X
N
with respect to tariff
N
under
vertical specialization. The elasticity can once again be separated into an intensive and an
extensive margin effect:
JX
N
J
N
X
N

N
=

N
X
N
__
ox
N
()
o
N
J0()
q
NO
q
N
_ +

N
X
N
_x
N
(
N
)0
i
(
N
)
o
N
o
N
x
N
(
N0
)0
i
(
N0
)
o
N0
o
N
_

Using the definition of equilibrium individual exports from equation (4) and using the
assumption that economy l is small enough so that a change in
N

dx
N
(q)
d:
N
= e
x
N
:
N
.

Inserting this into the above equation and rearranging, we obtain:

dX
N
d :
N
X
N
:
N
= e + [
x
N
(q
N
)u
|
(q
N
)q
N
X
N

q
N
:
N
:
N
q
N

x
N
(q
NO
)u
|
(q
NO
)q
NO
X
N

q
NO
:
N
:
N
q
NO
. (B-6)

We have shown above that
q
N
:
N
:
N
q
N
=
s
s-1
. Furthermore, it is straightforward to derive from
equation (14) that:

dq
NO
q
NO
:
N
d:
N
=
s
s-1
(_ 1) < u, where _ =
_
n
N
n
S
]
s-1
_
S
]
s
_
n
N
n
S
]
s-1
_
S
]
s
-1
> 1.

Inserting these cut-off elasticities into (B-6) and rearranging:

JX
N
J
N
X
N

N
= e +
e
e 1
_
x
N
(
N
)0
i
(
N
)
N
x
N
(
N0
)0
i
(
N0
)
N0
X
N
_

[
x
N
(q
N
)u
|
(q
N
)q
N
-x
N
(q
NO
)u
|
(q
NO
)q
NO
X
N
+ _
x
N
(q
NO
)u
|
(q
NO
)q
NO
X
N
(B-7)

Using the definition of firm-level exports from equation (5) and the definition of the
distribution of productivity shocks in equation (3), we can rewrite aggregate exports in the
following way:

X
N
= ] x
N
()J0()
q
NO
q
N
=
1
z-(s-1)
|x
N
(
N
)0
i
(
N
)
N
x
N
(
N0
)0
i
(
N0
)
N0
].

Inserting this equation into (B-7) and rearranging, we obtain:

JX
N
J
N
X
N

N
= e + (z (e 1))
e
e 1

_1 + _
x
N
(q
NO
)
x
NO
(q
NO
)
x
NO
(q
NO
)u
|
(q
NO
)q
NO
x
N
(q
N
)u
|
(q
N
)q
N
-x
NO
(q
NO
)u
|
(q
NO
)q
NO
]. (B-8)

Inserting equations (5), (12), (B-3) and the definition of _ into (B-8), we can rearrange
the equation to:

dX
N
d :
N
X
N
:
N
= e + (z (e 1))
s
s-1
_1 +
X
NO
X
N

1
_
n
N
n
S
]
s-1
_
S
]
s
-1
_. (B-9)

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ADB Economics
Working Paper Series
We develop a theoretical model in which vertical specialization gives frms the fexibility to
circumvent country-specifc tarif changes by switching their assembly location abroad. Using
frm-level and province-level export data from the Peoples Republic of China, we provide
evidence in line with the theoretical model.
About the Asian Development Bank
ADBs vision is an Asia and Pacifc region free of poverty. Its mission is to help its developing
member countries reduce poverty and improve the quality of life of their people. Despite the
regions many successes, it remains home to two-thirds of the worlds poor: 1.7 billion people who
live on less than $2 a day, with 828 million struggling on less than $1.25 a day. ADB is committed
to reducing poverty through inclusive economic growth, environmentally sustainable growth,
and regional integration.
Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main
instruments for helping its developing member countries are policy dialogue, loans, equity
investments, guarantees, grants, and technical assistance.
www.adb.org/economics

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Vertical Specialization, Tarif Shirking and Trade

Alyson C. Ma and Ari Van Assche

(:) is the domestic price.

is the measure of varieties available in

(:) is the price of variety : in economy i. Firms treat A

as fixed since they are too small to

Vertical Specialization, Tariff Shirking, and Trade 9

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